Richard Lipsey and the Phillips Curve

Richard Lipsey has had an extraordinarily long and productive career as both an economic theorist and an empirical economist, making numerous important contributions in almost all branches of economics. (See, for example, the citation about Lipsey as a fellow of the Canadian Economics Association.) In addition, his many textbooks have been enormously influential in advocating that economists should strive to make their discipline empirically relevant by actually subjecting their theories to meaningful empirical tests in which refutation is a realistic possibility not just a sign that the researcher was insufficiently creative in theorizing or in performing the data analysis.

One of Lipsey’s most important early contributions was his 1960 paper on the Phillips Curve “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1862-1957: A Further Analysis” in which he extended W A. Phillips’s original results, and he has continued to write about the Phillips Curve ever since. Lipsey, in line with his empiricist philosophical position, has consistently argued that a well-supported empirical relationship should not be dismissed simply because of a purely theoretical argument about how expectations are formed. In other words, the argument that adjustments in inflation expectations would cause the short-run Phillips curve relation captured by empirical estimates of the relationship between inflation and unemployment may well be valid (as was actually recognized early on by Samuelson and Solow in their famous paper suggesting that the Phillips Curve could be interpreted as a menu of alternative combinations of inflation and unemployment from which policy-makers could choose) in some general qualitative sense. But that does not mean that it had to be accepted as an undisputable axiom of economics that the long-run relationship between unemployment and inflation is necessarily vertical, as Friedman and Phelps and Lucas convinced most of the economics profession in the late 1960s and early 1970s.

A few months ago, Lipsey was kind enough to send me a draft of the paper that he presented at the annual meeting of the History of Economics Society; the paper is called “The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium.” Here is the abstract of the paper.

To make the argument that the behaviour of modern industrial economies since the 1990s is inconsistent with theories in which there is a unique ergodic macro equilibrium, the paper starts by reviewing both the early Keynesian theory in which there was no unique level of income to which the economy was inevitably drawn and the debate about the amount of demand pressure at which it was best of maintain the economy: high aggregate demand and some inflationary pressure or lower aggregate demand and a stable price level. It then covers the rise of the simple Phillips curve and its expectations-augmented version, which introduced into current macro theory a natural rate of unemployment (and its associated equilibrium level of national income). This rate was also a NAIRU, the only rate consistent with stable inflation. It is then argued that the current behaviour of many modern economies in which there is a credible policy to maintain a low and steady inflation rate is inconsistent with the existence of either a unique natural rate or a NAIRU but is consistent with evolutionary theory in which there is perpetual change driven by endogenous technological advance. Instead of a NAIRU evolutionary economies have a non-inflationary band of unemployment (a NAIBU) indicating a range of unemployment and income over with the inflation rate is stable. The paper concludes with the observation that the great pre-Phillips curve debates of the 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflationary pressure, were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, long-run Phillips curve located at the unique equilibrium level of unemployment.

Back in January, I wrote a post about the Lucas Critique in which I pointed out that his “proof” that the Phillips Curve is vertical in his celebrated paper on econometric policy evaluation was no proof at all, but simply a very special example in which the only disequilibrium permitted in the model – a misperception of the future price level – would lead an econometrician to estimate a negatively sloped relation between inflation and employment even though under correct expectations of inflation the relationship would be vertical. Allowing for a wider range of behavioral responses, I suggested, might well change the relation between inflation and output even under correctly expected inflation. In his new paper, Lipsey correctly points out that Friedman and Phelps and Lucas, and subsequent New Classical and New Keynesian theoreticians, who have embraced the vertical Phillips Curve doctrine as an article of faith, are also assuming, based on essentially no evidence, that there is a unique macro equilibrium. But, there is very strong evidence to suggest that, in fact, any deviation from an initial equilibrium (or equilibrium time path) is likely to cause changes that, in and of themselves, cause a change in conditions that will propel the system toward a new and different equilibrium time path, rather than return to the time path the system had been moving along before it was disturbed. See my post of almost a year ago about a paper, “Does history matter?: Empirical analysis of evolutionary versus stationary equilibrium views of the economy,” by Carlaw and Lipsey.)

Lipsey concludes his paper with a quotation from his article “The Phillips Curve” published in the volume Famous Figures and Diagrams in Economics edited by Mark Blaug and Peter Lloyd.

Perhaps [then] Keynesians were too hasty in following the New Classical economists in accepting the view that follows from static [and all EWD] models that stable rates of wage and price inflation are poised on the razor’s edge of a unique NAIRU and its accompanying Y*. The alternative does not require a long term Phillips curve trade off, nor does it deny the possibility of accelerating inflations of the kind that have bedevilled many third world countries. It is merely states that industrialised economies with low expected inflation rates may be less precisely responsive than current theory assumes because they are subject to many lags and inertias, and are operating in an ever-changing and uncertain world of endogenous technological change, which has no unique long term static equilibrium. If so, the economy may not be similar to the smoothly functioning mechanical world of Newtonian mechanics but rather to the imperfectly evolving world of evolutionary biology. The Phillips relation then changes from being a precise curve to being a band within which various combinations of inflation and unemployment are possible but outside of which inflation tends to accelerate or decelerate. Perhaps then the great [pre-Phillips curve] debates of the 1940s and early 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflation[ary pressure], were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, one-dimensional, long run Phillips curve located at a unique equilibrium Y* and NAIRU.”

It’s also worth remembering that Phillips stated the relationship between wages and unemployment broke down when inflation was imported. Ie that the relationship was contingent on endogenous inflation which is how Keynes described it in the GT (at each commodity level). If you look closely at Phillips’ dataset you will also see it didnt work during the late 1870’s – when international prices were falling. (He reckoned the issue was due to poor index constriction!) Given the impact that exogenous drivers of the general price level have in a highly globalised environment, it begs the question as to how useful the relationship is. Indeed, if you look at recent advances in Hecksher Ohlin labour market models you can see the effect of globalisation on depressing domestic wages. This is probably why inflation fell in those countries that didnt target inflation as highlighted by Mankiw in 2006.

I have often wondered if the 1960s and 1970s were economic aberrations, and thus created a body of thought and some empirical observations that no longer apply.

The 1960s was an era of Big Labor, Big Auto, Big Steel, limited foreign trade, lower immigration, and heavily regulated transportation, telecommunications and financial industries, and a top marginal tax rate of 90 percent. Big retailers (Sears) printed annual catalogs and stuck with the prices for a year. No Internet for off-market sales.

The 1960-70s was a perfect storm for lock-step inflation, as it was called then. You cut money supply and you get decrease in output but not much inflation reduction. Arthur Burns was not crazy.

Okay, today labor is dead, autos are globalized, whole industries deregged, trade is huge, immigration has been huge, the top marginal tax rate cut in half and more.

Who has pricing leverage today? The phone companies? Labor? Steel (remember they used to announced price hikes in the JFK days). Trucking deregged, no more pretty stewardesses and fixed airline fares.

Reg Q is gone, fixed (and fat) stockbroker commissions are gone.
The Internet is ridge with deals and information, and think about Craigslist.

The economics profession was deeply influenced by the 1960s and 1970s inflation. But that lesson is dead.

I do not think the lockstep inflation spiral applies anymore. It requires labor and producers to have some pricing leverage, which today they do not.

Tim, Thanks for the references. I am not familiar with McDonald’s work, but it looks interesting. The point he makes about Joan Robinson having anticipated the Friedman-Phelps argument (there were many others who did so as well) when inflation is rising was new to me.

Tom, Clearly in any macromodel the theoretical effect of inflation on unemployment rate depends critically on the source of inflation. How does the distinction between what you call an exogenous inflation versus endogenous inflation match up with the distinction between inflation from supply shocks versus inflation from demand shocks.

Benjamin, You are right to point out the many ways in which economies have changed since the 1970s. But Milton Friedman would never have accepted the idea that inflation was caused by labor unions and microeconomic regulations rather than by monetary expansion. And I am not convinced that modern economies are structurally invulnerable to inflation. Oh, and by the way, Arthur Burns, under whom Friedman worked at the National Bureau of Economic Research, never once cut the money supply in his tenure at the Fed.

David–
Yes…Burns concluded that inflation could be reduced, but only at great cost to real output…today he is scorned, but at the time he was probably right…imagine a model with absolute price rigidity…or even a model in which powerful economic actors accept lower output to gain higher prices (OPEC).
Sure Friedman was right…he also had a secure job and was not an entrepreneur with his life savings at stake…Today (my main point) the Fed could cause inflation but the good news is that it will have to try a lot harder…as you know we are teetering on the edge of deflation…PCE deflator headed towards 1 percent…

Not sure if I can answer your question to the extent that supply and demand shocks can clearly be both endogenous and exogenous. To me the challenge is that many economists argue that supply and demand shocks are just shocks – temporary phenomenon and therefore won’t impact inflation expectations which seems to have been Friedmans’ legacy. This view might well be the case for many/most shocks (eg price of wheat due to poor harvest, temporary tax cuts and volatile energy prices). However, this does not explain structural changes which I don’t think can be described as “shocks”.

For example the fall in the general price level in the UK between 1873 – 1896 was more of a structural shift than a supply side shock. It clearly impacted expectations of the general price level accelerating consumption as real wages rose due to lower cost imported goods from France, Germany and the US who were industrialising fast (profits of UK businesses fell). The integration of China and India into the global supply chain from the 1990s was similar to the 1870’s in that it caused prices in certain (imported) goods to fall which also impacted inflation expectations explaining why inflation fell in those countries that didn’t target it. Quite a few central bankers from emerging market countries (eg Chile, South Africa) have been trying to wrestle with the issues of long run rises in energy prices feeding through to expectations suggesting that at some point they stop being shocks and start becoming structural changes.

Hence I think the way in which prices change and impact the economy is not as well understood as is generally claimed (Leijonhufvud). Which is why I am mostly sceptical of the utility of Taylor rules which ignores these “exogenous” effects. Using an extended Hecksher Ohlin labour market model (see link below) one can see the minority of innovation workers with rising wages whilst the rest of the labour force has seen downward pressure on wages. Hence the idea that looser monetary policy would automatically feed through to rising inflation assumes that nominal wages will start rising, but nominal wage levels in a globalised economy are being increasingly determined exogenously it would appear.

Benjamin, Burns was complicit in, if not an instigator of, Nixon’s imposition of price controls in 1971. If he felt that reducing inflation was not worth the cost in terms of reduced output and employment, I could respect that position. But his role in imposing wage and price controls and then accelerating monetary growth (under some duress from Nixon to be sure) in the runup to the 1972 election was a disgrace, and, as far as I am concerned, his reputation was irreparably damaged by his actions at the Fed.

Wonks Anonymous, I oppose any and all attempts to rehabilitate Arthur Burns.

Tom, Structural changes should affect real variables, not nominal variables. If competition from cheap foreign labor may be holding down real wages, but that doesn’t mean that monetary expansion is powerless to raise nominal wages corresponding to whatever real wage is determined by structural factors. In my view, nominal price declines in the 1872-96 period were caused by relatively slow growth in the world gold stock in that period while there is a big increase in monetary gold demand resulting from a widespread shift from bimetallic standards (effectively on silver) to gold standards.

Blue Aurora, No I was not aware of that anthology. Thanks for mentioning it. I must have been aware of the fact Phillips himself understood the logic of the Lucas Critique, as evidenced by the quotation below. However, it is one more example of something that I was knew, but have forgotten. It always helps to be reminded of stuff. By the way, Lucas himself in his classic paper acknowledged that the critique had been previously stated by others, notably Tinbergen. But for some some reason, the critique only seemed to be taken seriously after it was (re)stated by Lucas.

“For Phillips . . ., controlling the economy meant modifying the structure of the system with the aim of reducing the variance of target variables. Yet, this definition implied that one could not predict the effects of a control from an econometric model without first identifying the changes in the underlying structural model that would be caused by the control. Pessimistic about solving this identification problem, which has reappeared in the Lucas critique, Phillips in 1967 accepted a chair in economics at the Australian National University where he devoted his attention to Chinese economic studies.”

David, I agree that the world gold stock did grow relatively slowly to demand during the period, however, it’s hard to see how rising productivity growth does not have any impact on prices.

Also, if monetary expansion is used to raise nominal wages surely this would feed through into higher expected inflation – so there would be no sustainable increase in real wages. Moreover, from an industry perspective in a globalised economy such increases seem to trigger firms to outsource labour to lower cost regions.

Tom, And I agree that rapid productivity growth would tend to cause output prices to fall or to rise less rapidly than otherwise. I agree that raising nominal wages cannot cause a sustainable increase in real wages, but under certain circumstances raising nominal wages can prevent a transitional decrease in employment that can have significant adverse cyclical effects.

About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.